Fisher’s Theory of
Debt Deflation
Irving Fisher, Multi-millionaire
“ Stock prices have reached what looks like a permanently high
plateau. I do not feel that there will soon, if ever, be a fifty or
sixty point break below present levels, such as Mr. Babson has
predicted. I expect to see the stock market a good deal higher
than it is today within a few months.”
(Irving Fisher, New York Times, October 15 1929)
Fisher’s pre-Great Depression Model
Fisher’s pre‐Great Depression model treated finance as just like
any other market, with supply and demand setting an
equilibrium price. However, in building his models, he made two
assumptions to handle the fact that, unlike the market for say,
apples, transactions in finance markets involved receiving
something now (a loan) in return for payments made in the
future.
Fisher’s pre-Great Depression Model
Fisher assumed:
“ (A) The market must be cleared—and cleared with respect to
every interval of time.”
(B) “The debts must be paid.” (Fisher 1930, The Theory of
Interest, p. 495)
Irving Fisher, pauper
We may tentatively assume that, ordinarily and within wide
limits, all, or almost all, economic variables tend, in a general
way, toward a stable equilibrium... But the exact equilibrium
thus sought is seldom reached and never long maintained. New
disturbances are, humanly speaking, sure to occur, so that, in
actual fact, any variable is almost always above or below the
ideal equilibrium...
Irving Fisher, pauper
It is as absurd to assume that, for any long period of time, the
variables in the economic organization, or any part of them, will
"stay put," in perfect equilibrium, as to assume that the Atlantic
Ocean can ever be without a wave. (Fisher 1933, p. 339)
A Disequilibrium Model
A disequilibrium‐based analysis was therefore needed, and that
is what Fisher provided. He had to identify the key variables
whose disequilibrium levels led to a Depression, and here he
argued that the two key factors were "over‐indebtedness to start
with and deflation following soon after".
A Disequilibrium Model
•
He ruled out other factors—such as mere overconfidence—in a
very poignant passage, given what ultimately happened to his
own highly leveraged personal financial position:
I fancy that over‐confidence seldom does any great
harm except when, as, and if, it beguiles its victims
into debt. (p. 341)
Fisher’s Debt Deflation Theory
Fisher then argued that a starting position of over‐indebtedness
and low inflation in the 1920s led to a chain reaction that
caused the Great Depression:
"(1) Debt liquidation leads to distress selling and to…
Fisher’s Debt Deflation Theory
(2) Contraction of deposit currency, as bank loans are paid off,
and to a slowing down of velocity of circulation. This contraction
of deposits and of their velocity, precipitated by distress selling,
causes…
Fisher’s Debt Deflation Theory
(3) A fall in the level of prices, in other words, a swelling of the
dollar. Assuming, as above stated, that this fall of prices is not
interfered with by reflation or otherwise, there must be…
Fisher’s Debt Deflation Theory
(4) A still greater fall in the net worths of business, precipitating
bankruptcies and …
Fisher’s Debt Deflation Theory
(5) A like fall in profits, which in a "capitalistic," that is, a
private‐profit society, leads the concerns which are running at a
loss to make …
Fisher’s Debt Deflation Theory
(6) A reduction in output, in trade and in employment of labor.
These losses, bankruptcies, and unemployment, lead to …
Fisher’s Debt Deflation Theory
(7) Pessimism and loss of confidence, which in turn lead to …
Fisher’s Debt Deflation Theory
(8) Hoarding and slowing down still more the velocity of
circulation. The above eight changes cause …
Fisher’s Debt Deflation Theory
(9) Complicated disturbances in the rates of interest, in
particular, a fall in the nominal, or money, rates and a rise in
the real, or commodity, rates of interest." (p. 342)
Bernanke’s View
Fisher’ s idea was less influential in academic circles, though,
because of the counterargument that debt‐deflation represented
no more than a redistribution from one group (debtors) to
another (creditors). Absent implausibly large differences in
marginal spending propensities among the groups, it was
suggested, pure redistributions should have no significant
macroeconomic effects. ”
(Bernanke 2000, Essays on the Great Depression, p. 24)
Bernanke Was Wrong
If the world were in equilibrium, with debtors carrying the
equilibrium level of debt, all markets clearing, and all debts
being repaid, this neoclassical conclusion would be true. But in
the real world, when debtors have taken on excessive debt,
where the market doesn't clear as it falls, and where numerous
debtors default, a debt‐deflation isn't merely "a redistribution
from one group (debtors) to another (creditors)", but a huge
shock to aggregate demand.
Bernanke Was Wrong
Crucially, even though Bernanke notes at the beginning of his
book that "the premise of this essay is that declines in aggregate
demand were the dominant factor in the onset of the
Depression" (p. ix), his equilibrium perspective made it
impossible for him to see the obvious cause of the decline: the
change from rising debt boosting aggregate demand to falling
debt reducing it.
Bernanke Was Wrong
In equilibrium, aggregate demand equals aggregate supply
(GDP), and deflation simply transfers some demand from
debtors to creditors (since the real rate of interest is higher
when prices are falling). But in disequilibrium, aggregate
demand is the sum of GDP plus the change in debt. Rising
debt thus augments demand during a boom; but falling debt
subtracts from it during a slump.
Bernanke Was Wrong
In the 1920s, private debt reached unprecedented levels, and
this rising debt was a large part of the apparent prosperity of
the Roaring Twenties: debt was the fuel that made the Stock
Market soar.
But when the Stock Market Crash hit, debt reduction took the
place of debt expansion, and reduction in debt was the source of
the fall in aggregate demand that caused the Great Depression.